A common theme among health reformers has been that the small-group and individual markets for health insurance are too concentrated and thus inadequately competitive. The proposed remedy is to have more independent insurers compete within local markets.
Reformers left of center on the ideological spectrum – President Obama prominent among them – advanced this thesis frequently in their advocacy of a new, public health plan, or of insurance cooperatives, for Americans under age 65.
Reformers right of center appear to subscribe to the same thesis when they argue for allowing insurers to sell health insurance across state lines. An alternative interpretation, however, is that they merely wish to permit what finance people call “regulatory arbitrage” – that is, shopping by consumers among different regimens of health-insurance regulation and their associated costs.
Widgets versus health insurance. As someone who has long taught micro-economics I understand, of course, why competition among multiple producers in the market for the legendary widget will drive down the price of widgets to minimum feasible production costs, plus a small profit margin, if widget makers buy the inputs they use in similarly competitive input markets. This is the standard textbook case of perfect competition.
I have some trouble, however, grafting this model onto the market for health insurance, which is not quite like the market for the legendary widget.
To arrive at the premium a commercial health insurer will charge for a particular policy and risk class, the insurer’s actuaries will first project the expected per capita outlays (X) for the covered health care products and services that insured members in that risk class are likely to trigger over the insured period. This is by far the largest cost component embodied in the premium.
To these actuarially expected outlays on purely medical benefits (X), the insurer will then add allowances for the cost of marketing the policy (M) (advertising and broker commissions), administering it (A), and the desired profit margin (P) needed to stay in business over the long term. The sum of these components will equal the premium.
What Component Of Premiums Would Be Reduced By Increasing The Number Of Insurers?
The question then is which of these components – X, M, A and P – would be driven down by having more insurers compete for enrollees in a given market area.
The prime candidate would seem to be P, the profit margin. In practice, however, that margin is smaller than seems widely believed – typically much below 10 percent and often below 5 percent.
There might be some economies in administrative costs (A) per insured in the case of large insurers allowed to sell policies across state lines in the small-group and individual markets. However, these economies would pale compared to the savings that might be achieved in the market for medical benefits.
The marketing costs (M) would, if anything, increase with the number of insurers competing in a local market.
The same, it seems to me, applies to the largest outlay insurers make — medical benefits (X). The bulk of the medical benefits procured by an insurer for residents in a given market area are produced by providers within that market area. In general, both private and public insurers have only limited, if any, control over the volume of the medical benefits that local clinical decision makers ask insurers to purchase for the insured.
Furthermore, the larger the number of insurance companies active in a local market, the smaller any insurer’s market share will be — other things being equal — and the less leverage any insurer will have in bargaining with area providers over the prices of health care.
Growing supply-side concentration. Over the past decade, the supply side of the health care sector in many localities has become ever more concentrated, as hospitals formed systems and physicians joined together in larger groups. The current nouvelle vague – so-called Accountable Care Organizations (ACOs) – will only further encourage that concentration. I find it hard to believe that, in the face of this trend, fragmenting the buy side of health care even more would serve the goal of cost containment.
Ideally, in my view, the market for health insurance would be oligopolistic, which means that only a few insurers — each with some market clout vis à vis providers — would compete for enrollees in a local market. What the ideal number would be is an interesting question on which economists can have a lively debate.
So what am I missing here? Why do so many otherwise sensible people believe that fragmenting the buy side of the health care market even more than it already is will help contain the rising cost of health care? I would argue just the opposite.
Uwe Reinhardt, noted Princeton economist, originally published this article in the Health Affairs (copyright). This article is subject to a Creative Commons license.